Breakeven Analysis: Understanding the Relationship between Sales, Fixed and Variable Costs, Study notes of Decision Making

Download Breakeven Analysis: Understanding the Relationship between Sales, Fixed and Variable Costs and more Study notes Decision Making in PDF only on Docsity! Chapter 20 Breakeven analysis and short-term decision making REAL WORLD CASE This case study shows a typical situation in which management accounting can be helpful. Read the case study now but only attempt the discussion points after you have finished studying the chapter. Flying Brands is a company which delivers goods to customers. The business began some years ago by flying flowers from the Channel Islands to the UK mainland. The Group has continued to drive profits forward with profit before tax up by 24%, and profit before tax and before all exceptional items up by 10%. The business is focused on profitable growth, and although sales in 2003 showed a fall on 2002 of 3%, the temptation to chase marginal customers was resisted, and a greater emphasis was placed on increasing customer spend and improving operational efficiency. This is reflected in the contribution margin for the two main brands improving to 35% compared to 32% in 2002 . . . Overheads increased during the year by 5%, slightly above inflation, as the marketing team was considerably strengthened. Corporate overheads comprise the costs of the chief executive, the finance director, the non-executive directors and the legal, professional and other fees connected with the running of a public company . . . By driving increasing volumes of orders through our existing operations, we will see economies of scale and substantially improved recovery of fixed overheads. Source: Flying Brands Limited, Annual report 2004, pp. 10 and 11. www.fbgl.co.uk, www.flyingflowers.com/ Discussion points 1 How did the company improve its contribution to fixed overheads and profit? 2 What was the alternative strategy for improving contribution which the company rejected? FAM_C20.qxd 12/4/06 13:59 Page 530 Chapter 20 Breakeven analysis and short-term decision making 531 Contents 20.1 Introduction 532 20.2 Cost behaviour: fixed and variable costs 532 20.2.1 The economist’s view 533 20.2.2 The accountant’s view 534 20.2.3 Cost–volume–profit analysis 537 20.3 Breakeven analysis 537 20.3.1 Calculating the break-even point 537 20.3.2 Breakeven chart 538 20.3.3 Profit–volume graph 539 20.4 Using breakeven analysis 540 20.4.1 Covering fixed costs and making a profit 541 20.4.2 Beyond the breakeven point 541 20.4.3 Margin of safety 542 20.4.4 Change in selling price 542 20.4.5 Change in variable cost 542 20.4.6 Change in fixed costs 542 20.5 Limitations of breakeven analysis 543 20.6 Applications of cost–volume–profit analysis 543 20.6.1 Special order to use up spare capacity 544 20.6.2 Abandonment of a line of business 544 20.6.3 Existence of a limiting factor 544 20.6.4 In-house activity versus bought-in contract 544 20.7 Cases in short-term decision making 545 20.7.1 Decisions on special orders 545 20.7.2 Abandonment decisions 546 20.7.3 Existence of limiting factors 547 20.7.4 Make or buy 548 20.7.5 In-house activity compared to bought-in services 549 20.7.6 Relevant costs 549 20.8 Pricing decisions 550 20.8.1 Economic factors affecting pricing 550 20.8.2 Full cost pricing 550 20.8.3 Mark-up percentages 551 20.8.4 Limitations of full cost pricing 551 20.8.5 Marginal cost pricing 552 20.9 Summary 552 Learning outcomes After reading this chapter you should be able to: l Explain how the accountant’s view of cost behaviour differs from that of the economist. l Define and calculate contribution and breakeven point, and prepare a breakeven chart and a profit–volume chart. l Use breakeven analysis to explore the effect of changing unit selling price, unit variable cost or fixed cost. l Explain the limitations of breakeven analysis. l Explain applications of cost–volume–profit analysis. l Show how calculation of contribution can be applied in short-term decision making. l Explain how pricing decisions may be related to cost considerations. FAM_C20.qxd 12/4/06 13:59 Page 531 Part 7 Decision making534 starts at zero when there is zero activity. It rises rapidly when supply begins and customers are willing to pay relatively high prices for the goods. Then, as supply increases, the marginal selling price of each item decreases progressively as it becomes more difficult to sell larger volumes of output. Where the total revenue line is below the total cost line the business is making a loss, and where the total revenue line is above the total cost line the business is making a profit. The business represented by the graph in Exhibit 20.2 shows losses at the left-hand and right-hand sides of the diagram and a profit in the centre. Successful businesses aim to stay in the profit-making region. 20.2.2 The accountant’s view The economist’s view of costs covers a very wide range of output. In any particular period, especially in the short term, the actual range of output will be relatively narrow. Looking at Exhibit 20.2 the lines close to the breakeven point are close to being straight lines over a narrow range either side. Accounting assumes that at any point in time this relatively narrow range is available in practice and so the cost and revenue curves are approximately straight lines. The data in Exhibit 20.3 is used in this section to illustrate the accountant’s view of how costs change with levels of activity. The graph in Exhibit 20.2 represents activity level changes which could take some time to achieve as the business grows. The accountant takes a much shorter time perspective and looks at a relatively limited range of activity that might be achieved within that time period. In those circumstances, it may be reasonable to use straight- line graphs rather than curves, although great care is needed before assuming it is safe to use straight lines. Using the data of Exhibit 20.3, a graph of variable cost is shown in Exhibit 20.4 and a graph of fixed cost is shown in Exhibit 20.5. Exhibit 20.3 Table of data showing variable and fixed costs Activity level 0 units 100 units 200 units 300 units £ £ £ £ Variable cost 0 10 20 30 Fixed cost 20 20 20 20 Total cost 20 30 40 50 Exhibit 20.4 Variable cost FAM_C20.qxd 12/4/06 13:59 Page 534 Chapter 20 Breakeven analysis and short-term decision making 535 In Exhibit 20.6, these two graphs are added together to give a graph of total cost. The total cost starts at £20 and increases by £10 for every 100 units of activity. The total cost line meets the vertical axis at the fixed cost amount of £20. The slope of the total cost line gives a picture of how fast the variable costs are rising as activity level increases. The profit of the business is measured by comparing costs with revenues. Here again, the accountant takes the view that it may be reasonable, over a short time-scale and relatively limited range of activity, to use a straight line. In Exhibit 20.7, a sales line Exhibit 20.5 Fixed cost Exhibit 20.6 Total cost Exhibit 20.7 Total cost and total sales FAM_C20.qxd 12/4/06 13:59 Page 535 Part 7 Decision making536 Exhibit 20.8 The features of a breakeven chart is added based on a selling price of 30 pence per unit, so that total sales are £30 for 100 units, £60 for 200 units and £90 for 300 units. The sales line is below the cost line at the left-hand side of the graph, crossing the cost line when the activity is 100 units. This shows that for activity levels below 100 units the business will make a loss. At 100 units of activity the business makes neither profit nor loss. This is called the breakeven point. Beyond 100 units of activity the business makes a profit and the amount of profit is measured by the vertical difference between the sales and cost lines. Definition The breakeven point is that point of activity (measured as sales volume) where total sales and total cost are equal, so that there is neither profit nor loss. The graph shown in Exhibit 20.7 is more commonly called a breakeven chart. It shows the activity level at which total costs equal total sales and at which the business makes neither a profit nor a loss. It also shows what happens to costs and revenues on either side of this breakeven point. If activity falls below the breakeven level, then the amount of loss will be measured by the vertical distance between the cost and sales line. If activity rises above the breakeven level then the amount of profit will be measured by the vertical distance between the sales and cost line. If the business is operating at an activity level higher than the breakeven point, the distance between these two points is called the margin of safety. The margin of safety indicates how much activity has to fall from its present level before profit becomes zero. Definition The margin of safety is the difference between the breakeven sales and the normal level of sales (measured in units or in £s of sales). Exhibit 20.8 summarises the various features of a breakeven chart. The use of a chart of this type to depict the behaviour of costs and sales over a range of activity in the short term has been found extremely helpful in presenting management accounting information to non-financial managers who are involved in making decisions which have financial consequences. FAM_C20.qxd 12/4/06 13:59 Page 536 Chapter 20 Breakeven analysis and short-term decision making 539 The sales line will therefore join the points (0, £0) and (900, £810): £ Variable cost of 900 souvenirs at 50 pence each = 450 Fixed cost = 200 Total cost 650 The total cost line joins (0, £200) and (900, £650). Exhibit 20.11 shows the breakeven chart with a breakeven point at 500 units sold. Gridlines are added to show the points plotted. Exhibit 20.11 Breakeven chart 20.3.3 Profit–volume graph Defining the profit–volume ratio Profit is an important aspect of most management accounting reports. However, the breakeven chart does not show directly the amount of profit. It has to be estimated by measuring the vertical distance between the sales and total cost lines. There is another form of graph used in management accounting called a profit–volume chart. On the horizontal axis is plotted the volume, measured by activity level in £s of sales, and on the vertical axis is plotted the profit at that activity level. The activity level is measured in £s of sales in order that the slope of the graph matches the profit/volume ratio, a slightly confusing name for the ratio which calculates contribution as a percentage of sales value: Profit/volume ratio equals × 100 Exhibit 20.12 sets out a diagram showing the main features of a profit–volume chart. Illustration of a profit–volume chart Taking the data used in preparing Exhibit 20.10, the preparation of a profit–volume graph requires only the profit line to be drawn. When sales are zero, there will be a loss equal to the fixed cost, which gives the first point to plot at (£0, −£200). When 900 units are sold the sales are £810 and the profit is £160, giving the second point to plot at (£810, £160). The result is shown in Exhibit 20.13. The gridlines are included to show where the profit line has been plotted. The breakeven point of zero profit Contribution per unit Selling price per unit FAM_C20.qxd 12/4/06 13:59 Page 539 Part 7 Decision making540 or loss is at a sales level of £450. The graph rises by £40 of profit for every £90 increase in sales activity, giving a slope of 44.4%. The profit/volume ratio is calculated by formula as: = = 44.4% 20.4 Using breakeven analysis Breakeven analysis is a very useful tool. It may be used to answer questions of the following type: l What level of sales is necessary to cover fixed costs and make a specified profit? l What is the effect of contribution per unit beyond the breakeven point? l What happens to the breakeven point when the selling price of one unit changes? l What happens to the breakeven point when the variable cost per unit changes? l What happens to the breakeven point when the fixed costs change? Each of these questions is now dealt with in this section by an illustration and an explanation following the illustration. 40 pence 90 pence Contribution per unit Sales price per unit Exhibit 20.12 Profit–volume chart Exhibit 20.13 Profit–volume chart using data from the ‘market trader’ case study FAM_C20.qxd 12/4/06 13:59 Page 540 Chapter 20 Breakeven analysis and short-term decision making 541 Activity 20.3 Activity 20.4 20.4.1 Covering fixed costs and making a profit To find the level of sales necessary to cover fixed costs and make a specified profit requires a knowledge of selling price per unit, variable cost per unit, and the fixed costs together with the desired profit. These are set out in the data table. Data Selling price per unit 80 pence Variable cost per unit 30 pence Fixed cost £300 Desired level of profit £400 The contribution per unit is 50 pence (80 pence − 30 pence). To find the breakeven point, the fixed costs of £300 are divided by the contribution per unit to obtain a breakeven point of 600 units. To meet fixed costs of £300 and desired profit of £400 requires the contribution to cover £700 in all. This is achieved by selling 1,400 units. Volume of sales required = = 1,400 units Check that 1,400 units at a contribution of 50 pence each gives a total contribution of £700. It is always a useful precaution to check the arithmetic of a calculation as a safeguard against carelessness. 20.4.2 Beyond the breakeven point Beyond the breakeven point the fixed costs are covered and the sales of further units are making a contribution to profit. The higher the contribution per unit, the greater the profit from any particular level of activity. The data table sets out some information on selling prices, variable costs and fixed costs of two products. Data A dry-cleaning shop takes two types of clothing. Jackets cost £6 to clean and the customer is charged £9 per garment. Coats cost £10 to clean and the customer is charged £12 per garment. The monthly fixed costs are £600 for each type of garment (representing the rental costs of two different types of machine). The shop expects to clean 500 jackets and 500 coats each month. Before reading the analysis following Exhibit 20.13, calculate the contribution made by each product, work out the breakeven point of each, and then explore the effect on the breakeven point of: (a) changes in the price charged to customers; (b) changes in the variable costs; and (c) changes in the fixed costs. If you have access to a spreadsheet package this is the kind of problem for which spreadsheets are highly suitable. The calculations set out in Exhibit 20.14 show that, although both products have the same fixed costs, the jackets have a lower breakeven point because they make a higher contribution per unit. Beyond the breakeven point they continue to contribute more per unit. The profits at any given level of activity are therefore higher for jackets. 700 0.5 FAM_C20.qxd 12/4/06 13:59 Page 541 Part 7 Decision making544 20.6.1 Special order to use up spare capacity In the short term, a business must ensure that the revenue from each item of activity at least covers variable costs and makes a contribution to fixed costs. Once the fixed costs are covered by contribution, the greater the level of activity, the higher the profit. When the business reaches full capacity there will be a new element of fixed cost to consider should the business decide to increase its capacity. If there is no increase in capacity, then the business should concentrate on those activities producing the highest contribution per unit or per item. But supposing the business is not operating at full capacity. Should it lower its sales price in an attempt to increase the volume of activity? The question may arise in the form of a request from a customer for a special price for a particular order. (Customers may well know that the business is not operating at full capacity and may therefore try to use their bargaining power to force a lower sales price.) Should the business accept the special order? Cost–volume–profit analysis gives the answer that the special order is acceptable provided the sales price per item covers the variable costs per item and provided there is no alternative use for the spare capacity which could result in a higher contribution per item. 20.6.2 Abandonment of a line of business The management of a business may be concerned because one line of business appears not to be covering all its costs. This situation may arise particularly where costs are being used for score-keeping purposes and all fixed costs have been allocated to products. As was shown in Chapter 18, the allocation of fixed costs to products is a process which is somewhat arbitrary in nature, and is not relevant to decision making because the fixed costs are incurred irrespective of whether any business activity takes place. When a line of business comes under scrutiny as to its profitability, cost–volume– profit analysis shows that in the short term it is worth continuing with the line if it makes a contribution to fixed costs. If the line of business is abandoned and noth- ing better takes its place, then that contribution is lost but the fixed costs run on regardless. 20.6.3 Existence of a limiting factor In the short term, it may be that one of the inputs to a business activity is restricted in its availability. There may be a shortage of raw materials or a limited supply of skilled labour. There may be a delivery delay on machinery or a planning restriction which prevents the extension of a building on the business premises. There may then be a need to choose from a range of possible activities so as to maximise short-term profit. The item which is restricted in availability is called the limiting factor. Cost–volume–profit analysis shows that maximisation of profit will occur if the activity is chosen which gives the highest contribution per unit of limiting factor. 20.6.4 In-house activity versus bought-in contract For a manufacturing business, there may be a decision between making a component in-house as compared with buying the item ready-made. For a service business there may be a decision between employing staff in-house and using the services of an agency which supplies staff as and when required. Cost–volume–profit analysis shows that the decision should be based on comparison of variable costs per unit, relating this to the difference in fixed costs between the options. FAM_C20.qxd 12/4/06 13:59 Page 544 Chapter 20 Breakeven analysis and short-term decision making 545 20.7 Cases in short-term decision making Cost–volume–profit analysis is particularly well suited to management needs in short- term decision making. Fiona McTaggart now discusses four cases she has come across where cost–volume–profit analysis has been relevant. The first relates to a decision about taking on a special order to fill a gap where the business was not running at full capacity. The second relates to a potential abandonment of a line of business, the third deals with a limiting factor causing scarcity of an input to the production process, and the fourth relates to buying in services. 20.7.1 Decisions on special orders FIONA: My first story is about a car hire business in a holiday resort which was experi- encing a temporary fall in activity in the run-up to the start of the tourist season. Their normal charge was £3.00 per mile, to cover all costs including the driver’s wages. A tele- phone installation company offered a three-month contract to run engineers between two towns on a return journey of 100 miles, at a fixed price of £180 per journey. The car hire company asked my advice about accepting this offer of £1.80 per mile. I asked the company what the drivers and cars would be doing each day if the con- tract was not taken up and the answer was that they would not be doing anything other than waiting at the depot and cleaning their cars. My advice was that, on that basis, the contract would be worth undertaking if it covered the variable costs of each journey and made a contribution to fixed costs and profit. We sat down to look at the fixed costs and produced the statement shown Exhibit 20.15. Quite deliberately I did not write any amounts against the separate items of fixed costs because I wanted to emphasise that these are the unavoidable element which will arise whether or not the contract is taken up. From the data provided, I calculated the variable cost per mile as 20 pence for petrol and 8 pence for tyres, giving 28 pence in all. The normal charge of £3.00 per mile is intended to cover this 28 pence per mile plus the fixed cost per mile, amounting to £2.10 per mile using the average annual mileage per car. That total cost of £2.38 per mile leaves a profit of 62 pence per mile or £24,800 per annum if the average mileage is achieved. It is clear that to cover all costs the charge of £3.00 is probably about right, but if the drivers and cars are otherwise unoccupied, extra journeys on the special contract con- tribute £1.52 per mile (£1.80 − £0.28) to fixed costs and profit. I advised them to take up the contract on two conditions: 1 they must be as sure as they could be that there will not be an upturn in business during the hire period which would mean they were turning down the possibility of carrying passengers who would pay £3.00 per mile; and 2 if the journeys involve extra payments to drivers for overtime or late-night work, those extra payments should be regarded as part of the variable cost of the contract and the costings recalculated on that basis. They took my advice and carried out the contract. It fitted perfectly into the quiet period of business and the company realised later that the contract had made a useful contribution to profit at a time when drivers and cars would otherwise have been inactive. In Fiona’s example, the company made use of the idea that, in the short term, any contract is worth taking on if it covers variable costs and makes some contribution to fixed costs and profit. Care needs to be taken that the special order does not create a precedent for future work, particularly if existing customers find that special treatment is being given which appears to undercut the price they are paying. The company may FAM_C20.qxd 12/4/06 13:59 Page 545 Part 7 Decision making546 find it difficult in future to return to the price which covers all costs. In the long term, the company must charge a price which covers fixed costs as well as variable costs if it is to survive. Fiona’s second illustration relates to a decision on abandoning a line of activity. 20.7.2 Abandonment decisions FIONA: A private tuition college was providing two types of secretarial training course. The first was teaching wordprocessing and the second was teaching office skills. The college had produced the profit and loss statement shown in Exhibit 20.16. On the basis of this profit and loss statement the owners of the business were on the point of cancelling all further courses in office skills. I asked them how they had decided on the allocation of fixed overheads and they explained that these comprised primarily administrative staff costs and permanent teaching staff, plus items such as rent and business rates as well as depreciation of wordprocessors and of the equipment used in the cabin which had been set up to simulate the most up-to-date office conditions. The cabin itself was depreciated over 20 years. Fixed overhead which could be allocated directly to the relevant courses, such as depreciation of equipment, was allocated in its entirety to the relevant course type. This approach was also used for teaching costs where these were specific to one course type. Fixed overhead which could apply to each type of course, such as administrative staff salaries, was spread in proportion to the number of courses given. Exhibit 20.15 Analysis of variable and fixed costs of car hire firm Variable costs: Petrol £1.20 per litre Fuel consumption 6 miles per litre Tyre costs £1,600 per set of four tyres Tyre replacement every 20,000 miles Fixed costs: £84,000 These covered: Driver’s wages Insurance Licence fee for airport waiting Licence fee to town council Depreciation of vehicle Annual testing Radio control membership Average annual mileage per car: 40,000 miles Exhibit 20.16 Information for abandonment decision Wordprocessing Office skills Total £000s £000s £000s Tuition fee income 485 500 985 Variable costs 200 330 530 Fixed overhead 120 220 340 Total costs 320 550 870 Profit/(loss) 165 (50) 115 FAM_C20.qxd 12/4/06 13:59 Page 546 Chapter 20 Breakeven analysis and short-term decision making 549 The external price looks attractive at first glance but, before I can advise the car manu- facturer, I need to know more about the fixed cost. It is currently £1,500,000 per annum (£30 times 50,000 components). If the company can avoid the fixed cost by purchasing from the outside supplier, then I will compare the additional variable cost of £20 (£100 − £80) with the saving of £1,500,000. The company breaks even at 75,000 components (calculated as fixed cost saving of £1,500,000 divided by additional variable cost of £20). If demand is less than 75,000 then it is more cost effective to buy from the external supplier. If demand is more than 75,000 then it is more cost effective to manufacture in-house (provided fixed costs do not change at a higher level of output). If the fixed cost of £1,500,000 cannot be avoided (perhaps it represents rent and property costs which would be incurred even if there were no production), then there is no advantage in buying from the external supplier. The relevant comparison in such a situation is between the variable cost of £80 and the external price of £100. I would also advise the company that non-financial matters such as quality control and reliability of supply should be taken into consideration when deciding on external purchase rather than internal production. 20.7.5 In-house activity compared to bought-in services In her final example, Fiona describes a situation where a company was considering buying in services rather than employing its own staff. Cost–volume–profit analysis implies that the decision should be based on the costs saved by not undertaking the activity in-house (the variable costs and any fixed costs that are avoidable) together with the costs incurred in buying the product or service from an external supplier (price multiplied by quantity purchased). FIONA: A company had been employing its own legal department, comprising a qualified solicitor and two assistants. The solicitor was about to retire and the company had to decide whether to advertise for a replacement or to use a commercial law service as and when required. There would be no redundancy costs in respect of the two assistants because the younger one could be redeployed to a vacancy elsewhere in the organisation and the other would continue to be required as the internal contact with the commercial law service. I showed the management that, because the commercial law service would charge on an hourly basis, the costs to be compared were the variable costs per hour charged by the commercial service and the fixed costs per annum of the in-house solicitor’s salary. We compared the hourly charge rate of £400 with the solicitor’s salary of £60,000 and the assistant’s salary of £36,000 and worked out that the breakeven point would be 240 hours of the commercial law service each year. If more than 240 hours are requested next year, it would be worth continuing the in-house service. 20.7.6 Relevant costs Throughout the examples above Fiona McTaggart has made use of the distinction between fixed and variable costs. She has also distinguished relevant from non- relevant costs. Generally the fixed costs have not been relevant to decision making but the variable costs have been relevant. Some fixed costs are relevant where they may be avoided by a specific course of action but others are not relevant because they may not be avoided. Definition Relevant costs are those future costs which will be affected by a decision to be taken. Non-relevant costs will not be affected by the decision. FAM_C20.qxd 12/4/06 13:59 Page 549 Part 7 Decision making550 20.8 Pricing decisions One of the most important decisions taken by a business is that of pricing its product. If the price is too high, there will be no demand. If the price is too low, the organisa- tion will be making a lower profit than could be achieved. 20.8.1 Economic factors affecting pricing The method of arriving at a price depends on economic factors. If the business has a monopoly position (where one supplier has control of the market), it will be able to dictate its own price. However, the higher the price, the greater the attraction to incomers to break down the monopoly powers in seeking to share the benefits enjoyed by the monopolist. Where the business is a market leader, it may be able to set its price by reference to covering its full costs and making a satisfactory profit. If there are only a few large sellers, each with a significant share of the market, the situation is described as an oligopoly. These few large sellers may compete with each other on price or they may prefer to set their prices at a level which covers all costs and to keep the price reasonably constant while competing on non-price factors such as quality of the product. In a perfectly competitive market, no one supplier is in a position to dictate prices. Economic theory shows that the optimal price will be achieved where marginal cost equals marginal revenue. In other words, the additional cost of producing one more item of output equals the additional revenue obtained by selling that item. While the additional revenue exceeds the additional cost, the economist argues that it is worth producing more. When the additional revenue is less than the additional cost, production will not take place in the perfectly competitive market. Pricing policy therefore depends primarily on the circumstances of the business. In many situations there is strong competition and the organisation must accept the market price and try to maximise its profit by controlling cost. In that situation, the most efficient organisation will achieve the highest profit as a percentage of sales. Sometimes the organisation may be faced with pressure from customers to reduce selling price. The decision to do so will require an evaluation of the lower price against costs. In other cases, the organisation may have some ability to control price and therefore has to decide on a price related to what the market will bear and related to covering its costs. There are therefore some situations in which a cost-based pricing formula may be appropriate. These are now considered. 20.8.2 Full cost pricing Full cost pricing is also called cost-plus pricing. The manager who is setting the price for goods or services calculates the total cost per unit of output and adds a percentage to that cost called the percentage mark-up on cost. Calculation of total cost requires allocation of overhead costs. It was shown in Chapter 18 that there is more than one method of allocating production overhead costs. The same variety of method may be found in allocation of non-production over- head. Different organisations will have different ideas on which costs they want to cover in a cost-based pricing approach. What really matters is that the organisation understands its cost structure and ensures that all overhead costs are covered in some way by revenue in the longer term. When the company is a price taker and is asked to take a lower price, or not to raise its existing price, then cost-plus pricing is still important, but it is also important for FAM_C20.qxd 12/4/06 13:59 Page 550 Chapter 20 Breakeven analysis and short-term decision making 551 the organisation to ensure that it makes a decision using relevant costs. If the pricing decision is based on a short-term perspective, then the organisation may decide to accept any price provided that the additional revenue covers the variable costs. That is the accountant’s version of the economist’s rule that marginal cost should equal marginal revenue. In management accounting terms, the item should make a contribution to fixed costs but does not necessarily need to cover all fixed costs. In the longer term, the business must cover all costs, whether fixed or variable, but it is possible that some fixed costs may be avoidable. If, for example, a reduced price is forced upon the business, it may accept this in the short term but also take a long-term decision to cut back on permanent staff and rental of premises. Such a decision may be unpleasant to take, in terms of human consequences for staff, but may allow the business to survive in a harsher economic situation. 20.8.3 Mark-up percentages The full cost approach to pricing requires a percentage to be added to cost. Where does this percentage come from? The answer is that it depends very much on the type of business and the type of product. Where the market is competitive, mark-up percentages will be low and the organisation relies for its success on a high volume of sales activity. This may be seen in the operation of supermarkets, which charge lower prices than the small shops and therefore have lower margins on the items sold, but customers take away their purchases by the car load rather than in small parcels. In the case of supermarket chains there is another aspect to pricing in that they them- selves buy from suppliers. The supermarkets may use the strength of their position to dictate price terms to the suppliers, so that the margins are not as low as they would seem from the prices charged to the customers. In some industries, or for some products, there appears to be a ‘normal’ mark-up which all companies apply fairly closely. This ‘normal’ mark-up may be so characteristic that it is used by the auditor as a check on how reasonable the gross profit amount appears and is also used by the tax authorities as a check on whether all sales and profit are being declared for taxation purposes. For those businesses which are in a position to apply cost-plus pricing, it may encourage stability in the pricing structure because other businesses in the same industry may be in a position to predict the behaviour of competitors. Companies in an industry will know the mix of variable and fixed costs in the industry and will therefore have a good idea of how competitors’ profits will be affected by a change of price. 20.8.4 Limitations of full cost pricing Full cost pricing, if used without sufficient care, may not take into account the demand for the product. A business may charge a profit margin of 20% on sales when market research could have shown that the potential customers would have accepted up to 25% as a profit margin and still bought the goods or services. Apportionment of fixed costs is an arbitrary process, with more than one approach being available. The profit estimated using the cost-plus basis will depend on the apportionment of fixed costs. If the price is distorted by the costing process, an optimal level of sales may not be achieved. There may be a lack of benefit to customers where businesses are able to set prices on a cost-plus basis and, as a consequence, a group of companies works together to ‘agree’ a price. Such a situation is described in economics as a ‘cartel’, and in some situations a government will legislate against price fixing by cartels because it creates a monopoly position in a situation which appears at first sight to be competitive. FAM_C20.qxd 12/4/06 13:59 Page 551 Part 7 Decision making554 B Application B20.1 [S] Fixed costs are £5,000. Variable cost per unit is £3 and the unit selling price is £5.50. What is the breakeven volume of sales? B20.2 [S] Plot a breakeven chart based on the following data and label the features of interest on the chart: Number of units Fixed cost Variable cost Total cost Sales £ £ £ £ 10 200 100 300 150 20 200 200 400 300 30 200 300 500 450 40 200 400 600 600 50 200 500 700 750 B20.3 [S] Montrose Glass Products Ltd manufactures three ranges of high-quality paper-weights – Basic, Standard and Deluxe. Its accountant has prepared a draft budget for Year 7: Basic Standard Deluxe Total £000s £000s £000s £000s Revenue 45 35 40 120 Material 15 10 10 35 Labour 20 15 5 40 Variable overhead 5 12 5 22 Fixed overhead 9 5 6 20 49 42 26 117 Profit/(loss) (4) (7) 14 3 Fixed overheads are allocated to each product line on the basis of direct labour hours. The directors are concerned about the viability of the company and are currently considering the cessation of both Basic and Standard ranges, since both are apparently making losses. Required (a) If the directors close down only the manufacture of Basic paperweights, what is the effect on total profit? (b) If the directors close down only the manufacture of Standard paperweights, what is the effect on total profit? (c) What is the best decision with regard to keeping profit as high as possible? B20.4 [S] Chris Gibson Kitchenware Limited sells kitchen appliances to department stores. Product costs are ascertained using an absorption costing system from which the following statement has been prepared in respect of the business’s three product lines: Dishwashers Fridges Ovens Total £000s £000s £000s £000s Sales 180 330 270 780 Less total costs (200) (250) (220) (670) Profit/(loss) (20) 8 50 110 It has been estimated that costs are 60% variable and 40% fixed. FAM_C20.qxd 12/4/06 13:59 Page 554 Chapter 20 Breakeven analysis and short-term decision making 555 Required (a) Restate the table distinguishing variable and fixed costs. (b) Advise whether dishwashers should be dropped from the product range in order to improve profitability. B20.5 [S] Capital Tours Limited sells weekend tours of London for £200 per person. Last month 1,000 tours were sold and costs were £180,000 (representing a total cost per tour of £180). These costs included £60,000 which were fixed costs. A local college wishing to send 200 students on an educational trip has offered Capital Tours £140 per tour. Required (a) Explain with reasons whether Capital Tours should accept the offer. (b) Explain the danger, in the long run, of Capital Tours using prices based on variable (marginal) costing. C Problem solving and evaluation C20.1 [S] Dairyproducts Ltd has recently developed sales of cream in aerosol dispensers which are sold alongside the company’s traditional products of cartons of cream and packets of cheese. The company is now considering the sale of cream cheese in aerosol dispensers. It is company policy that any new product must be capable of generating sufficient profit to cover all costs, including estimated initial marketing and advertising expenditure of £1,000,000. Current weekly production, with unit costs and selling prices, is as follows: Units of Variable Fixed Selling output cost (£) cost (£) price (£) Cartons of cream 400,000 0.45 0.15 0.75 Aerosol cans of cream 96,000 0.50 0.25 1.05 Packets of cheese 280,000 1.00 0.20 1.30 Sales volume is equal to production volume. A 50-week trading year is assumed. Rates of absorption of fixed costs are based on current levels of output. In order to produce cream cheese in aerosol dispensers, the aerosol machine would require modification at a cost of £400,000 which is to be recovered through sales within one year. Additional annual fixed costs of £500,000 would be incurred in manufacturing the new product. Variable cost of production would be 50 pence per can. Initial research has estimated demand as follows: Price per can (£) Maximum weekly demand (cans) 1.50 60,000 1.40 80,000 1.15 100,000 There is adequate capacity on the aerosol machine, but the factory is operating near capacity in other areas. The new product would have to be produced by reducing production elsewhere and two alternatives have been identified: (a) reduce production of cream cartons by 20% per annum; or (b) reduce production of packet cheese by 25% per annum. FAM_C20.qxd 12/4/06 13:59 Page 555 Part 7 Decision making556 The directors consider that the new product must cover any loss of profit caused by this reduction in volume. They are also aware that market research has shown growing customer dissatisfaction because of wastage with cream sold in cartons. Required Prepare a memorandum to the board of directors of Dairyproducts Ltd showing the outcome of the alternative courses of action open to the company and make a recommendation on the most profitable. C20.2 A company is able to sell four products and is planning its production mix for the next period. Estimated costs, sales and production data are as follows: Product L M N O £ £ £ £ Selling price per unit 60 90 120 108 Less Variable costs Labour (at £6 per hour) 18 12 42 30 Material (at £3 per kg) 18 54 30 36 = Contribution per unit 24 24 48 42 Resources per unit Labour (hours) 3 2 7 5 Material (kg) 6 18 10 12 Maximum demand (units) 5,000 5,000 5,000 5,000 Required (a) Based on the foregoing information, show the most profitable production mix under each of the following mutually exclusive assumptions: (i) if labour hours are limited to 50,000 in a period; or (ii) if material is limited to 110,000 kg in a period. (b) Write a short explanation, suitable for sending to the production director, explaining your recommendation in each case. Cases for study groups Case 20.1 Leisure Furniture Ltd produces furniture for hotels and public houses using specific designs prepared by firms of interior design consultants. Business is brisk and the market is highly com- petitive with a number of rival companies tendering for work. The company’s pricing policy, based on marginal costing (variable costing) techniques, is generating high sales. The main activity of Home Furniture Ltd is the production of a limited range of standard lounge suites for household use. The company also offers a service constructing furniture to customers’ designs. This work is undertaken to utilise any spare capacity. The main customers of the com- pany are the major chains of furniture retailers. Due to recession, consumer spending on household durables has decreased recently and, as a result, the company is experiencing a significant reduction in orders for its standard lounge suites. The market is unlikely to improve within the next year. The company’s pricing policy is to add a percentage mark-up to total cost. Required Explain why different pricing policies may be appropriate in different circumstances, illustrating your answer by reference to Leisure Furniture Ltd and Home Furniture Ltd. Case 20.2 In groups of three, take the role of finance director, production director and sales director in a company manufacturing pressure die castings, gravity die castings and sand castings. The FAM_C20.qxd 12/4/06 13:59 Page 556